Phasing in Tax Cuts Can Slow Economic Growth

May 3, 2004

Key elements of the 2001 tax cut were phased-in, and that may explain why the recovery went slowly at first, says Bruce Bartlett. Real gross domestic product grew at a 4.2 percent rate in the first three months of 2004, but it normally grows much faster in the early stages of economic expansions following a recession.

Back in the early 1980s, economist Arthur Laffer predicted that because the Reagan tax cut enacted in 1981 was not fully phased in until 1984, its impact on growth would be severely reduced. There was really no tax cut in 1981. As of 1982, the cumulative tax cut was 10 percent, rising to 18 percent in 1983 and 23 percent in 1984.

Prospects of lower tax rates in future years created incentives for individuals and businesses to reduce their income during 1981 and 1982 when tax rates were high, in order to realize that income in 1983 and 1984 when tax rates would be lower. Thus phasing in cuts to marginal tax rates can actually reduce growth initially, as people delay realizing income:

Real GDP jumped from minus 1.9 percent in 1982 to plus 4.5 percent in 1983 and 7.2 percent in 1984.

The immediate effect of the 2001 phased-in tax cuts was to reduce output in 2002 by 0.4 percent below what it would have been with a smaller, immediate tax cut, according new study from economists Christopher House and Matthew Shapiro.

The 2003 tax cut was much more effective because more of it took effect immediately, and thus may have contributed toward increased growth in the second half of 2003.

Thus we may owe the slowness of the economic recovery to those who thought that phasing-in the 2001 tax cut was the "responsible" thing to do.

Source: Bruce Bartlett, NCPA senior fellow, "Phase-In of '01 Tax Cut Not so Shrewd After All," May 3, 2004; see Christopher House and Matthew Shapiro, "Phased-In Tax Cuts and Economic Activity," National Bureau of Economic Analysis, w10415, April 2004.